A theory stating that there are important psychological and behavioral variables involved in investing in the stock market that provide opportunities for smart investors to profit. For example, when a certain stock or sector becomes “hot” and prices increase substantially without a change in the company’s fundamentals, behavioral finance theorists would attribute this to mass psychology. They therefore might short the stock in the long term, believing that eventually the psychological bubble will burst and they will profit.
So, we know now that behavioral finance is tied up to psychological and behavioral variables. This is occurring en masse, resulting in what we call “Mass Psychology”. The above definition actually takes into account the actions of the smart investors or also commonly known as smart money that we try to follow. The assumption is that smart money will attempt to do the opposite of the masses in order to benefit from the burst of the “Psychological Bubble”.
Another definition from Dictionary of Financial Terms goes like this:
Behavioral finance combines psychology and economics to explain why and how investors act and to analyze how that behavior affects the market.
Behavioral finance theorists point to the market phenomenon of hot stocks and bubbles, from the Dutch tulip bulb mania that caused a market crash in the 17th century to the more recent examples of junk bonds in the 1980s and Internet stocks in the 1990s, to validate their position that market prices can be affected by the irrational behavior of investors.
Behavioral finance is in conflict with the perspective of efficient market theory, which maintains that market prices are based on rational foundations, like the fundamental financial health and performance of a company.
Here, we learn that behavioral finance is an integration of 2 main fields of study, psychology and economics. The minds of individuals and how it perceives various situations at any given point of time has an impact on the markets. The movements in the market then is considered as irrational and therefore can lead to situations of extremes, commonly known as Bubbles. We also learn that behavioral finance as a theory is in direct conflict to the perspective of efficient market theory which gives more credence to market participants being rational and objective in thinking and action.
All in all, behavioral finance attempts to to fill in a void as there have been multiple documentations of long term historical phenomena in the securities market that contradict the efficient market hypothesis. It is here that behavioral finance come into the picture and proposes psychology based theories to try explain market anamolies.